The Wall Street Rider: What’s It All About?

As we noted here, Nancy Pelosi, Elizabeth Warren and most of the left wing of the Democratic Party turned against the continuing resolution/omnibus spending bill that squeaked through the House, ostensibly on the ground that it contained a “giveaway” to Wall Street. This was one of Pelosi’s several demagogic tweets:

Of course, the Democrats never made any attempt to explain what the “Boehner bank bailout” was, or why it was bad–an odd omission, since until now the Democrats have supported every bailout that has come down the pike. Is there something in the omnibus bill that makes the banking system riskier? As best I can tell, Section 630 of the bill is the offending provision, but you can’t really understand what it says without a prior knowledge of the Dodd-Frank provisions that are amended. I have not seen any mainstream media source that has tried to explain the issue coherently.

So I turned to a good friend who is an expert on risk management in the banking industry, and asked him to explain to our readers what is going on. Is this really a “bailout” provision, or a “giveaway” to banks? Or just more Democratic Party demagoguery? Here is his response:

This is a fairly technical, arcane issue in which reasonable positions could be taken on either side. But the newly defeated Dems see an opportunity to grandstand and highlight their phony economic populism with the time tested demagoguery of attacking “Wall Street” on a provision of the must-pass budget bill. The budget bill, like all such hastily contrived products of the legislative sausage factory, is a proverbial “Christmas tree” with all kinds of presents for special interests tucked under it. The Dodd-Frank revision is one of them.

It can be viewed as a technical correction to the original 2010 legislation. Here is a good summary of the state of play. The original legislation required major banks to “push out” some of their swaps business — for example, hedging the risk in their securities trading book for market making on behalf of clients — into “non-bank” subsidiaries which do not take deposits and are not insured or covered by the deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC). The idea was that a failure of one of these “push out” subsidiaries would have no call on the FDIC and “taxpayer bailouts”. Most more-or-less conventional hedging activity such as interest rate swaps, which mitigate risk in the banks’ loan books, was allowed to remain in the bank subsidiaries anyway. Hedging on equity securities and commodities would be forced into a non-bank subsidiary by the “push-out” rule. While relatively modest in volume terms for the banks, they are more profitable and likely have more strategic value for the banks’ clients (especially commodities hedging).

The revision would loosen this requirement of Dodd-Frank and permit much of the “push-out” swap activity to remain in the FDIC-insured bank subsidiaries of the large bank holding companies–mainly Citicorp, Bank of America, JPMorgan Chase and Wells Fargo. (Morgan Stanley and Goldman Sachs already conduct their swaps and derivatives activity in non-bank subsidiaries.) There are efficiency, cost and operational benefits for these institutions to retain all swaps activity done for hedging purposes in the bank subsidiaries, as explained by Fitch Ratings. Regional banks are interested in the change to Dodd-Frank as well since they do not typically have securities (non-bank) subsidiaries and conduct their swaps activities as a commercial banking service within their FDIC bank. But, admittedly, this is of interest to no more than about two dozen institutions, so politically could be viewed as narrow interest legislation.

However, there is no reason to think that the “push-out” provision of Dodd-Frank has lessened the “too big to fail” risk of major financial institutions at all! The recent analysis of the effects on “too big to fail”, i.e., “taxpayer” “bailouts” by the House Financial Services Committee, detailed the several mechanisms by which Dodd-Frank itself provides bailouts irrespective of whether an institution is an FDIC bank. Quite simply, if the concern is the risk in regulated FDIC backed banks, hedging of risks with swaps and other derivatives would seem beneficial. Indeed, both the former Federal Reserve Bank Chairman and FDIC Chairman, neither an ideologue and the latter a Democrat, support the change because to move this risk management hedging activity out of tightly regulated banks may actually increase systemic risk, as well as cost, for little discernible benefit.

So why oppose it? The counterargument is that all these activities simply cannot be controlled within the banks and inevitably will lead to future “bailouts”. In particular, I suspect that an exemption for high quality hedges on structured securities, i.e., bundles of underlying loans, has raised concerns among the Dems. But why a Credit Default Swap is a “risky bet,” but loans with the same borrower are not “risky bets,” has never been explained. At the end of the day, however, this would seem to be principally a technical question, not an existential do-or-die ideological issue. It seems pretty reasonable on the face of it to let “plain vanilla” hedging activities be conducted within banks for efficiency and risk management purposes, and the language seems to reflect this by carefully limiting what is carved out from the original Dodd-Frank (see pp. 616 – 618 of the budget bill). In fact, in an earlier incarnation, it was supported by 70 Democrats in the House. It is simply, on the merits, too arcane and obscure to be as politically salient as it seems to have become.

It is difficult to escape the conclusion that the Dems are seizing on this obscure, arguably narrow special interest legislation attached to the must-pass budget bill to make a larger political point, whatever minor technical merits there may be to their opposition. They have not made, in public, detailed substantive objections or revisions to tweak the language to address their concerns. They are simply taking the opportunity to demagogue against “Wall Street banks”, to “wave the bloody flag” of the 2008 crash by posturing about “risky” “complex derivatives” as “bets” made with “taxpayer-backed deposits” by greedy, unscrupulous banks. They have a political imperative to continue The Narrative around the financial crisis of 2008, aided as always by the clueless and collusive MSM.

But The Narrative is false. The image suggested is that the U.S. government just “gave” money to large banks, no questions asked, and thereby rescued them, apparently by making them whole on losses they incurred in a patently corrupt process. The banks weren’t in fact “given” any of our money. Indeed, most of the largest banks which were perfectly healthy were forced to take TARP funds so that there would be no stigma attached to the few large unhealthy banks–and the MANY unhealthy small community and regional banks.

The Fed and Treasury were acting as “lenders of last resort” to the entire banking system which was experiencing a classic run triggered by doubts about housing assets. This is EXACTLY what they are supposed to do: offer short term liquidity facilities in an emergency — loans, not grants — collateralized by illiquid but valuable assets. Indeed, in a bit of irony — or double standards — agencies like the FDIC and the Federal Reserve System, collectively designed to prevent and ameliorate runs on the banking system, were formerly proclaimed as Progressive and New Deal triumphs precisely because they prevented harm not to “the banks” but to their creditors and borrowers and the economy as a whole!

Speaking of Fed purchases transferring risk to “the taxpayer” is highly misleading. The central bank, though an agency of government, is not the taxpayer. It doesn’t require tax revenues to support its balance sheet. There is no economically meaningful sense in which it can become insolvent. If its so-called liabilities exceed its assets, that does not mean what it does for an entity whose spending is revenue constrained. The central bank uses its balance sheet and capital ratio just as price level stability management tools, and as a way of representing its operations to the public in a manner they are familiar with: the asset/liability language of financial accounting.

If the Fed buys a financial asset that is effectively worthless, and pays a million dollars for it, that just means it has created a million dollars and given it to the previous owner of that asset in exchange for virtually nothing. The taxpayer has not “lost money” in this transaction, because the Fed creates the money in the process of spending it.

Has the taxpayer been exposed to a “risk” as a result? Possibly. But not a budget or solvency risk. Only a potential inflation risk. That hasn’t been an issue in an environment in which the Fed has been fighting off deflation….

In contrast, look closely at who REALLY got “bailed out”, defined as having government grants or equity infusions or long term unremitted TARP or government guarantees funded and having anticipated permanent losses. It was Democrat constituencies: the Government Sponsored Entities (GSEs) used to inflate the housing bubble, FNMA and FHLMC (Fanny MAE and Freddie Mac), where losses will be realized in the scores of billions of dollars…and (ahem!) GM. The GM bailout really was a bailout — a transfer of taxpayer money to the UAW — in an incredibly shoddy and corrupt political process bypassing both bankruptcy and tax law and at a permanent loss.

So the Dems’ temper tantrum around the Dodd-Frank revision, an essentially minor tweak with bipartisan support, is really about something else. It throws down a marker in defense of their massive regulatory legislation of 2010 as preserving a win for their team. And it commandeers the critical budget legislation as a perfect platform to position themselves, after their abysmal showing among the white working and middle class in the mid terms, as economic populists taking on the banks, details and policy be damned. It is intended to repeat and reinforce The Narrative about “taxpayer” “bailed out” “Wall Street banks” — a false narrative and one that obscures the real bailout to Democratic interest groups. We can expect much more similar demagoguery no doubt as the left attempts to position as tribunes of the middle class. It’s Washington partisan hardball at its finest.

If you digested that, you understand the Democrats’ ploy better than any pundit in Washington D.C.